A tutorial on 529 college savings plans

My financial advisor scheduled my midyear review for tomorrow. In addition to our general discussion, I told her that I needed advice on 529 plans and saving for Sam’s college education. I figured it would help if I did a little research on my own so I could speak intelligently about the program and ask the right questions. Here’s what I learned:

Definition of a 529 saving plan: A plan that gives me the opportunity to contribute to a tax-deferred account established for our son (known as the named beneficiary) that’s invested in a savings vehicle, such as stock or a mutual fund.

How much do I need to save:

Child’s Current Age: One year old (or younger)
Average Cost Private College: $257,543
Average Cost Public College: $118,312

Click here to see cost estimates if your child is older. Or click here for World’s Simplest College Cost Calculator and finally click here for a more advanced version with columns for multiple children.

Federal tax benefits: 529 plans offer unsurpassed income tax breaks. Although your contributions are not deductible on your federal tax return, your investment grows tax-deferred, and distributions to pay for the beneficiary’s college costs come out federally tax-free. The tax-free treatment was made permanent with the Pension Protection Act of 2006.

State tax benefits: Your own state may offer some tax breaks as well (like an upfront deduction for your contributions or income exemption on withdrawals) in addition to the federal treatment. You should research what benefits residents receive for investing in your own state’s 529 plan… here. If you don’t get any benefits from your state, you have the pick of every 529 plan on offer… so compare plan features… here.

I learned that we don’t have to invest in a California plan. Other states may offer one that performs better and with lower fees. This is where I hope my financial advisor can offer guidance about the tax advantage of a California plan vs. elsewhere.

Another thing I learned is that Sam can attend college in any state. So while we live in California, we might invest in Georgia’s plan and send him to a college in New York. By investing in Georgia’s plan we’d miss out on any state tax benefits though, so I need to learn what is the specific state tax advantage with investing in a California plan.

One final note: Awhile back, one reader wrote in and asked if he could set up a 529 for his niece? He wasn’t planning on having kids, but wanted to start one for her. I replied that I didn’t know the answer… but now I do. You can even set one up for yourself if you think you might want to go back to grad school in ten years or he could reclaim the funds if his niece grows up and he changes his mind about helping. There’s a catch of course:

Donor retains control of funds: You, the donor, stay in control of the account. With few exceptions, the named beneficiary has no rights to the funds. You are the one who calls the shots; you decide when withdrawals are taken and for what purpose. Most plans even allow you to reclaim the funds for yourself any time you desire, no questions asked. (However, the earnings portion of the “non-qualified” withdrawal will be subject to income tax and an additional 10% penalty tax). Compare this level of control to a custodial account under the Uniform Transfers to Minors Acts (UTMA) and you will find the 529 plan gives you much more say in how your investment is used!

Any readers have other thoughts to add? Please feel free to comment below.

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Our state has no income tax so there was no benefit of using the state sponsored plan. Actually I think that they waived the $12 a year fee or something like that. Initially I used our state’s plan anyway. But then I did some research and decided to go with the Utah plan. They have very very low fees and good returns. Their online system is fantastically simple. I can log into one account to manage the funds for both of my kids rather than having to log in two separate times. You can do virtually everything online (you may have to mail in a signature card). I set up monthly automatic investing for both accounts. If I want to make an ad hoc deposit, it generally takes me about 90 seconds including logging in, setting it up, submitting, and confirming it. I chose the age-based portfolios which really takes the worry out of my head.

Good luck. If you can really start the account with $5000 and put in $400 a month, Sam will be in great shape.

Also, my state actually also have a prepaid tuition plan. This is the second incarnation of such a plan and the first was quite reasonable. The second (only 4 years later) is approximately 4x as expensive. Given the cost and the limitations regarding attending in-state schools, I decided to go with a 529. But if someone felt very committed to their child attending in-state public school, the pre-paid plans are another option.

In your case, with a 1 year old, a 529 might not be a bad idea. Be sure that when he reaches 14 or so that you start shifting the majority of it out of stocks. Don’t count on an age-specific plan to do that for you – most of them did a lousy job the last few years.

Those with older kids should consider whether a 529 is really worth it. Would you do better using college income tax credits, rather than the possibly small growth you get from the 529? Do you really want to pay penalties if your child doesn’t use the money for college?

And, all parents should consider if they actually want to share the existence of the 529 with their child. You’d be amazed how teens consider this “their” money, and then make decisions based on that! (Like, say, walking away from a full scholarship!!)